The Future of Venture Capital

Considering the Future of the Venture Capital Industry

I have been reading a lot of predictions of the future of venture capital and most–if not all–are pessimistic. The most optimistic pessimistic piece (forgive the contradiction) is from Union Square Ventures’ Fred Wilson he recently wrote:

“We need to get the venture capital business back to raising and investing less than $20bn per year on a sustainable basis. We are there now in terms of dollars being invested in startups. The last quarterly numbers were sub $4bn. And the amount of money coming into the VC business this year will be even less than what is going out.

The diet has begun. We are getting healthy again. I can see it in the market and I believe we will see it in the returns soon enough.”

But even he admits that a trimming of the fat from the venture capital industry probably won’t be a bad thing and even healthy for the bloated industry. In my own following of the industry I have come to a similar conclusion and tend to stray from the panicking VC’s who are calling for a federal bailout. Not that there isn’t reason to worry, probably the best explanation of the industry comes from Benchmark Capital’s Bill Gurley. He estimates that the venture capital industry could be cut to half as investors roll back their capital allocations to alternative assets. His analysis focuses on the problem of institutional investors allocating too much of their portfolio to illiquid alternative assets. Institutional investment managers began increasing investments in alternative assets such as levereaged buyouts (LBO’s), hedge funds and venture capital because these investments tend to produce a larger return with the higher risk.

The “Yale model” of investing heavily in alternative assets produced noticeable returns which was even more visible because institutional investors like pension funds and endowments usually disclose more information to the public. Other institutional investors felt a pressure to keep up with rival managers that were garnering such big gains on their investments so a trend started toward higher asset allocation to alternative assets. This was a great strategy during the buyout boom for private equity investments, recent high-earning hedge funds, before the real estate market went bust and in the late 90′s til the dot-com crash and middle of this decade for venture capital. Even now, it is unclear how hard institutional investors will be hit with losses on investments because their money is tied in such illiquid assets, many of which are not required to regularly report on a fund’s performance. But allocation to alternative assets has seen immense growth largely spurred by institutional investors who have come to rely on alternative investments to boost portfolio returns.

When the economy tanked and liquid assets like bonds and stocks plummeted institutional investors were stuck with a sinking liquid portion of their portfolio and an uncertain illiquid portion. The managers wanted to stave off any further losses but because they are committed long-term to hedge funds, buyout and venture capital funds it is not as easy to exit. Furthermore, they were still required to meet capital commitments from their investments which led to a few unattractive options facing institutional investors (Via AboveTheCrowd):

Sell more of it’s liquid securities. This is problematic because it further compromises the target asset allocation.

Try to sell the LBO commitments on the secondary market. As you might suspect the secondary market is extremely depressed. Some have even suggested that due to the forward cash need on an early LBO fund, an institution might have to “pay” to get out of the position, and to encourage someone else take on the future cash commitment.

Default on the commitment. While this does have penalties in most cases, it would not be out of the realm of possibilities for this to occur if the investor has lost faith in the manager, and it is early in the fund (with more cash needs in the future).

Try to raise more capital. Not surprisingly, donations to foundations and universities are down dramatically due to the overall decline in the capital markets. This makes this strategy unlikely.

No matter what option the manager decides to go with, he or his Board are probably going to have a smaller appetite for risk after suffering such heavy losses. Thus, institutional investors and even other accredited investors are likely to cut back allocation to alternative assets in a big way. This is the primary reason that Gurley and others suspect that the industry will be rolled back to a much smaller size. Another note is just how bloated the industry has become with inexperienced and/or inept VC’s sprouting up trying to raise capital in a tough economy, not to mention the number of proven VCs that have already admitted to problems raising capital and the ones that will undoubtedly struggle in the near future. But I don’t think that any serious predictions see the industry dissolving completely, there are still a lot of talented venture capitalists and brilliant entrepreneurs that will thrive in a bad market or a good one. Even in the midst of a major economic collapse venture capitalists invested $3.7 billion for 612 deals in the Q2 of 2009 according to a report by the NVCA and PWC. That’s a 15% increase in dollars which is nothing to sneeze in a time when many investors are still skeptical of even traditional investments.

I hope this has given some explanation to the future of venture capital and some background on the obstacles facing the industry.